Congress is focusing on the wrong deposit insurance reforms

Nathan Howard/Bloomberg

Adopting any legislative or regulatory reforms to increase the federal deposit insurance limit will only incentivize more bank risk-taking and result in more bank runs down the road. Policymakers should instead focus on further legitimizing private sector alternatives and removing the executive branch's unilateral authority to bail out both insured and uninsured depositors.

Members of Congress are focusing on the wrong reforms. On the same day the Senate Banking, Housing and Urban Affairs Committee held a hearing on deposit insurance, Sen. J.D. Vance, R-Ohio, introduced a bill to establish a new version of the Transaction Account Guarantee (TAG) program. The Payroll Account Guarantee Act of 2023 insures noninterest-bearing transaction accounts at all credit unions and any insured bank with less than $225 billion in assets. Similarly, a bill introduced by Rep. Blaine Luetkemeyer, R-Mo., would grant the Federal Deposit Insurance Corporation the authority to insure all noninterest-bearing transaction accounts for up to two months. In 2012, Republicans rejected an extension of the TAG program on the grounds that it largely turns banks into quasi-governmental entities. Bad ideas die hard.

The FDIC has proposed flawed ideas such as expanded deposit insurance for business payment accounts, or even unlimited deposit insurance. Former Federal Reserve board member Dan Tarullo admitted at an event at the Brookings Institution that new deposit insurance reforms will not stop bank runs. According to Tarullo, the idea of increasing deposit insurance coverage specifically for business payment accounts is "not going to solve the run issue." Unlimited deposit insurance would also be a bad idea because it could create "true zombie banks." Granting unlimited deposit insurance comes with significant costs. According to a paper published by the Roosevelt Institute, it comes with more burdensome regulation of banks, "much greater risk-taking by banks" and leads to "much larger assessments on banks."

These so-called reforms would increase moral hazard and incentivize riskier behavior resulting in future bank runs.

All these options would lead to increased assessments on banks, which would result in greater cost for taxpayers. Increased assessments, regardless of the size of the bank, hurt U.S. taxpayers in the form of more expensive banking services.

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There are also private sector alternatives that should be considered in lieu of increasing the deposit insurance limit or extending any temporary increase in deposit insurance coverage. For example, 56% of high-income countries have a form of private deposit insurance. Additionally, reciprocal, or "sweep" deposits can be used to cover more deposits with the current insurance cap. Sweep accounts are a private market solution to federal deposit insurance. For example, some community banks and regional banks offer insured cash sweep programs that allow depositors to spread around their money to "other FDIC-insured financial institutions" to earn higher interest and stay under the insurance limit.

Congress should also eliminate the systemic risk exception. Federal statute allows the Fed, Treasury Department and FDIC to coordinate and determine whether to waive certain requirements and insure all depositors. The Biden administration did just that when Silicon Valley Bank and Signature Bank collapsed. By using the systemic risk exception, large, sophisticated, uninsured depositors now know that the federal government could do it again — propagating moral hazard. This argument is bolstered by a 2010 report from the Government Accountability Office. The paper explains that the systemic risk exception worsens risky bank behavior and sets the expectation for "similar emergency actions in future crises, thereby weakening their incentives to properly manage risks and also creating the perception that some firms are too big to fail."

Instead of increasing the federal deposit insurance limit, even for business payment accounts, the systemic risk exception should be removed from statute to mitigate future expectations that depositors are protected even if they have uninsured deposits.

Unaccountable federal regulators should not possess unilateral power to insure all depositors at will.

Regulators claim that if regional banks are required to issue long-term debt this will reduce costs to the Deposit Insurance Fund. On the contrary, this will increase leverage, worsen financial instability and require banks to use earnings to pay down debt.

Raising the deposit insurance limit is an excuse for regulators to pile on additional regulations and capital requirements. To avoid an upward spiral of red tape, lawmakers need to stop focusing on misguided reforms and pay attention to the real problems: the systemic risk exception and moral hazard.